Commentary

Outperforming REITs could keep rolling

Commentary: Outperforming sector could still have room to grow

By

HowardGold

Columnist

NEW YORK (MarketWatch) — No sector in the U.S. market, not one, has done as well as real-estate investment trusts since the bull market began just about two years ago.

REITs, the publicly traded vehicles that own commercial property and pay out 90% of their income to shareholders, have beaten financials, consumer-discretionary stocks and even gold during the big rally from the market’s bottom in March 2009.

According to San Francisco-based Callan Associates, the FTSE NAREIT All Equity REIT Index gained 10.8% annually over the 10 years ending December 31, 2010. Only gold and emerging-markets stocks did better during that “lost decade” for the S&P 500.

So, can REITs continue their spectacular run? Certainly not at the pace they’ve set for the last couple of years, but I think they can still do well.

An improving economy, tight supply in commercial real-estate markets and REITs’ history of multiyear runs should tilt the scale toward the bulls. But current high valuations for REITs will keep me from buying more until the inevitable pullback occurs.

Why have REITs done so well? Partly because they did so poorly in the bear market, when the FTSE NAREIT All Equity Index lost 19% in 2007 and another 41% in 2008 — much worse than the S&P’s plunge.

“Real estate is a very capital-intensive business. As a result, REITs were a casualty of the financial meltdown,” explained Jim Sullivan, director of REIT research at Green Street Advisors, a Newport Beach, Calif.-based firm specializing in real estate. Since those dark days, though, “capital has become more plentiful and more reasonably priced — and public owners of commercial real estate have been primary beneficiaries of the recovery.”

They’ve had a huge edge over private owners, who until recently have been frozen out by banks unwilling or unable to lend. “Public REITs have more access to a variety of capital,” Sullivan said.

According to Cohen & Steers, a New York-based money management firm focusing on real-estate securities, REITs globally have raised more than $150 billion in total capital since 2008. They’ve used it to buy depressed property, clean up their balance sheets and do other good things.

Also, the problems plaguing the housing market — foreclosures, short sales, unemployment — have been good for REITs that own apartment buildings.

Data from the U.S. Census Bureau show the home-ownership rate dropped to 66.5% in the fourth quarter of 2010, the lowest level since 1998. Meanwhile, the rental-vacancy rate fell to 9.4%, its lowest level since 2003.

With more people renting, demand for apartments has been strong and landlords have been raising rents. So apartment REITs have been top performers, along with hotels — which, Sullivan elaborated, “cut expenses quickly and severely” in the recession and bounced back nicely with the recovery.

“No doubt a recovering economy is essential to commercial real estate in the long run,” he said.

About the author:• Howard R. Gold is a columnist for MarketWatch and
editor at large for MoneyShow.com.
Read more of his commentary and watch his videos at
howardrgold.com.
Follow him on Twitter at howardrgold.

Charles McKinley, a senior vice president for Cohen & Steers, thinks continued strong growth in emerging markets and a decent recovery in developed markets will lead to good earnings and dividend growth for REITs. (They currently yield on average in the mid-3% area.)

“Rarely have REITs operated with such attractively aligned tailwinds,” he wrote in a recent report.

Cohen & Steers, which invests in real estate worldwide, says the United States is in a good spot, as REITs already have seen strong growth in several sectors and face a very favorable supply/demand balance.

“Unlike previous commercial real-estate cycles, the most recent was marked by low levels of construction relative to existing housing stock … which has resulted in far less of the problematic oversupply that currently plagues residential markets in some countries,” McKinley said in the report.

Sullivan agreed that the limited supply could give commercial landlords more pricing power as the economy recovers.

So McKinley puts the United States midway between the trough and peak of a typical real-estate expansion cycle, as shown on the chart, which we reproduce with Cohen & Steers’ permission.

That means this could go on for a while. “Commercial real-estate recessions have historically been followed by multiyear expansions,” he wrote. “Each of the three major U.S. downturns since 1973 has been followed by an expansion lasting seven to 12 years. During these periods, total returns for REITs averaged 22% per year.”

There also are reasons to be wary, Green Street’s Sullivan said. Before the recent market retreat, REITs were changing hands “at a pretty meaningful premium [to] what their assets would be worth” in the private market, he told me.

They’re also “trading at much higher multiples” than stocks, he said — 20 times earnings for REITs versus 13 times for the S&P 500. On the other hand, “REITs look a little bit cheap compared with bond yields,” he pointed out.

The bottom line: “REITs appear fully priced at this point, but they could have some room to run.”

I agree, which is why I’d wait for a correction (like the current selloff) to buy more. Historically, REITs have added diversification to a portfolio, although in the current bull market they have appeared highly correlated with stocks. I think they should make up about 5% of your portfolio, maybe a bit more, depending on your age and risk tolerance.

Rather than buy individual REITs, which tend to be concentrated in one segment of the market, I’d look at funds and ETFs like VNQ, which I mentioned above. It has a low expense ratio of 0.1%. (Its mutual-fund cousin, which I own in my retirement account, has the ticker symbol
VGSIX, -1.90%
)

Other good U.S. REIT ETFs are the iShares Dow Jones US Real Estate
IYR, -1.66%
and the iShares Cohen & Steers Realty Majors
ICF, -1.98%

Actively managed funds with good long-term track records and relatively low expenses include Neuberger Berman Real Estate
NBRFX, -1.81%
and First American Real Estate Securities A
FREAX, -2.02%
Dividends paid by REITs don’t get the favorable tax treatment other stock dividends do, so I’d recommend them for retirement accounts.

A global real-estate ETF is SPDR Dow Jones International Real Estate
RWX, -0.81%
It owns property companies that are not necessarily REITs, but gives you exposure to real estate in markets like Europe and Japan, which are lagging our own now but could outperform later.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.